What is {term}? Physical Capital

Physical capital is one of the three main factors of production in economic theory. It consists of manmade goods that assist in the production process, for example, machinery, office supplies, transportation and computers.

BREAKING DOWN Physical Capital

In economic theory, factors of production are the inputs required to engage in the production of goods or services in pursuit of profit. Economists have not agreed on the exact delineation of each category; however, they generally agree that there are three main factors of production.

  • Land or natural resources. These factors include the land on which factories, shipping facilities or stores are built and the natural resources of a production process such as the corn needed to make tortilla chips or the iron ore used to make steel.
  • Human capital. This factor includes labor and other resources that humans can provide - education, experience or unique skills - that contribute to the production process.
  • Physical capital. This factor includes manmade goods that enable the production process such as machinery, buildings, computers and other goods needed for the production process to run smoothly.

Physical Capital and Firms

New or startup companies invest in physical capital early in their lifecycle, often before they have produced a single good or secured their first client.  For example, a company that manufactures microwave ovens must make several investments before it can sell a single microwave; the company must build a factory, purchase the machinery it needs to manufacture the product and it must manufacture some sample microwaves before any stores will carry their product.

The accumulation of physical capital with established firms and the associated investment required can pose a significant barrier to entry for new companies, particularly those in manufacturing-intensive industries. The diversification of physical capital is a measure of the level of diversification in a particular industry. From the perspective of physical capital, starting a new law firm is much easier than opening a new manufacturing plant. Theoretically, an attorney would need only an office, a phone and a computer. Consequently, law firms outnumber steel manufacturers by a significant margin.

Evaluating Physical Capital

Experts agree that physical capital is an important consideration in a company's valuation, but it is also one of the most difficult assets to evaluate. Fixed capital, for example, manufacturing machinery, has long-term value and is relatively illiquid because it is usually designed to fulfill a particular purpose. On the other hand, the value of physical capital can change over time or increase in value if the asset itself is upgraded or there are changes to the firm that affect its value.